Tim Bovee, Private Trader: FB: Volatility play

Update 11/10/2014: My iron condors traded for the last time on Friday, Nov. 7, and expired worthless the next day, Nov. 8.

FB remained within the boundaries of profitability during the entire 10-day lifespan of the position, losing a net of 6% over the period, or -218.8% annualized.

The iron condors produced a 100% yield on risk, or +3,650% annualized.

Update 10/28/2014: I've opened an iron condor on FB, as described below in the "Trade" section. There are nine trading days remaining until expiration.

The risk/reward ratio is high, at 8:1, as is not uncommon with wide iron condors. I'm swapping a high risk/reward ratio for greater odds in favor of success. The wisdom of that course of action will vary according to conditions on the chart. Given FB's high volatility in absolute terms, it seems to be a reasonable tradeoff.

The theory behind it is very much like the guiding motto of the Lunar settlers in Robert Heinlein's The Moon is a Harsh Mistress: TANSTAAFL -- There ain't no such thing as a free lunch. No where is this more true, in a precisely quantifiable way, than on the options market.

Facebook Inc. (FB) publishes earnings after the closing bell today, Oct. 28 in the midst of a volatility downtrend that has been underway for half a month. [FB in Wikipedia]

Volatility

Implied volatility stands at 43%, the 67th percentile of the prior rise, providing much room for continued decline in the falling trend that began Oct. 15 from 52%. The volatility chart shows the classic downward hook that is a prerequisite for my earnings plays.

Options are pricing in confidence that 68.2% of trades will fall between $75.93 and $85.61 over the next week, for a potential gain or loss of 6%, and between $78.57 and $82.97 over the next day.

Chart

FB has been in a major uptrend since September 2012, four months after it went public. The most recent upward leg of that trend began Oct. 15 and has set a higher high today.

Big picture, I count FB as being in the final leg of its rise, suggesting an increased likelihood that a reversal could be dramatic and devastating.

The most recent rise from Oct. 15 coincides precisely with the S&P 500. The difference is that while FB has attained a breakout high, the S&P 500 has not. That divergence gives me pause before coming down in favor of a post-earnings rise.

Moreover, the rise has been accompanied by falling volume, suggesting that the uptrend lacks credibility.

Volatility has consistently fallen immediately after each of the past four earnings announcements. The price has fallen after one announcement, risen after one and moved sideways after two. Although the current trend is up, I'm finding it difficult to pick a direction for this trade.

Earnings

Analysts expect Facebook's earnings to come in 60% higher than in the corresponding quarter a year earlier, although down slightly from the immediately prior quarter.

FB has surprised to the downside only once in the nine earnings announcements it has made since going public, in 2013. All other quarters surprised to the upside.

Trade

I intend to structure the position as a short iron condor, sold for a credit, using Weeklys that expire Nov. 7. The short options will be $70 for the puts and $90 for the calls, setting a range of profitability at expiration of that is 5% above the range implied by options pricing and 8% below. This provides an excellent cushion.

The calls have a 91% probability of expiring out of the money for maximum profit, and the puts have an 89% probability.

Decision for My Account

The chart has a good look to it, and an iron condor is a sideways trade, which means I don't have to pick a direction. It's possible to construct a fairly wide range of profitability while getting a good return.

Having said that, FB has high implied volatility at 43%, which is nearly three times the 16% volatility of SPY, the exchange-traded fund that tracks the S&P 500.

The average true range is $2.12, meaning that the boundaries of the volatility range are four or five days worth of the ATR away from the current price.

So the earnings announcement could easily trigger a wider swing. But the iron condor structure will provide some cushion that may well allow me get out with minimum damage in the case of a wide movement.

I intend to open a position in FB under my very short term volatility trading rules prior to the closing bell today.

-- Tim Bovee, Portland, Oregon, Oct. 28, 2014

References

My volatility trading rules can be read here. For a discussion of the rationale behind the rules, see my essay, "Rules for very short term trades".

From time to time I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

My method of scoring price and volatility responses to earnings, used in the "Chart" section, is the simplest imaginable. Looking at the four most recent earnings announcements, I give one point for a rising price or rising volatility in the week after the announcement, subtract a point to a falling price or volatility, and give a zero if the response is sideways movement. I then add the four quarters together to produce separate scores for price and volatility, and then add the two to produce a combined score.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.